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Is the Yen Doomed?

By: Axel Merk | Wednesday, November 28, 2012

Because of Japan's massive public debt burden, pundits have called for the
demise of the Japanese yen for years. Are the yen's fortunes finally changing?
Our analysis shows that the days of the yen being perceived as a safe haven
may soon be over. Let us elaborate.

So many foreign exchange ("FX") speculators have lost money shorting the yen
that the currency earned the nickname the widow maker. Indeed, as the yen has
had a weak patch as of late, some are already cautioning the trade might be
crowded. But we don't talk about a trade; we talk about a fundamental shift
in the dynamics that might finally be unfolding.

To understand the yen, consider the earthquakes that hit New Zealand and Japan
in early 2011: New Zealand's shaker caused the New Zealand dollar to fall;
Japan's earthquake, in contrast, pushed the yen higher. In the short-term,
earthquakes disrupt economic growth; conventional wisdom suggests less growth
leads to a weaker currency. However, economic growth and currencies do not
correlate as highly as one might expect. Indeed, everything appears backwards
in Japan, and there's a reason: historically, Japan has enjoyed a current
account surplus. As a result, Japan does not rely on inflows from abroad
to finance its budget deficit. Despite conventional wisdom, note that when
there's a shock to the economy, consumers save more/spend less, a positive
to a currency all else being equal (i.e., in the absence of a current account
deficit). In contrast, countries like the United States, or New Zealand for
that matter, have a current account deficit; in the absence of growth, foreigners
are less inclined to invest in the country, potentially depriving the country
of inflows needed to finance budget deficits and, in the process, putting downward
pressure on the currency. One reason why U.S. policy makers favor growth over
austerity is to encourage inflows to finance the deficit. On that note, the
lack of growth in the Eurozone, where the current account is roughly in balance,
may be bad for employment, but the euro has managed to hold up reasonably well
despite the crisis.

In some ways, when a country has a current account surplus, currency dynamics
may be counter-intuitive: the more dysfunctional the Japanese government, the
stronger the yen appears to have been in recent years. Since 2005, Japan has
had seven prime ministers, with another change likely soon. A government with
rotating heads suggests a government that doesn't get anything done. Usually
a government that "gets things done" is one that spends money, but Japan could
not even get an expeditious rebuilding effort under way after the earthquake
struck.

However, Japan's current account has been deteriorating in recent years. Consider
Japan's seasonally adjusted monthly current account balance below:

Japan is doing its part to accelerate the demise of its current account:

With one of the world's highest life expectancies, almost no net immigration
and falling birth rates, Japan's aging population is often cited as the
key-long term driver of the country's deteriorating current account balance.
The Japanese retire later than others in developed countries, cushioning
the impact somewhat.

The main "achievement" after the earthquake was announcing to abandon
nuclear energy. Increasingly relying on imported energy is bad news for
Japan's current account balance.

Rising tensions with China don't bode we'll for trade. Shinzo Abe, Japan's
likely prime minister to be is said to potentially escalate tensions further.
If correct, we expect Japan's current account balance to suffer as a result.

Why does this all matter? After all, the US has had a massive current account
deficit for years. The size of the current account deficit represents the amount
foreigners need to buy in assets (local financial assets or real assets) to
keep a currency from falling. With a current account deficit, Japan's debt
to GDP ratio of over 200% may suddenly matter, as Japan may need to offer higher
rates to attract foreigners to buy local assets (e.g., Japanese government
bonds). The trouble is that Japan's debt might be unsustainable at higher interest
rates. To the extent that Japan has a current account surplus, it doesn't matter
whether foreigners buy the yen, but those surpluses have fallen to deficits
recently and that trend looks set to continue.

Some will argue that it still doesn't matter, as Japan is currently more concerned
with negative rates. Our analysis, however, shows that the market does care:
in recent years, the yen often appreciated when there was a "flight to safety;" if
we use the VIX index, a popular measure of implied volatility of S&P 500
index options, as a proxy for the amount of fear in the market, then the yen
should show a high correlation with the index. Below please see the 12-month
rolling correlation of the yen versus the VIX index:

What the chart shows is that the yen isn't the safe haven it used to be. The
yen no longer is the "go to" place when fear is elevated. There might be many
reasons for this, but we like to look at it in the context of the current account
balance, shown in the previous chart: as the current account has deteriorated,
the yen's safe haven status appears to be eroding.

The one thing still going for the yen is that Japanese policy makers often
don't execute on their talk. For example, Abe's election rhetoric suggests
that the Bank of Japan (BOJ) will lose its independence as the government may
force it to increase its inflation target of 1% (which it has failed to achieve)
to 2 or 3 percent. But the BOJ has failed over and over again to live up to
its promises. A side effect of that is that in recent years the BOJ's balance
sheet has barely grown (the BOJ has "printed" very little money as one might
colloquially say); Japan did its money printing in the 90s.

However, it may matter little what the BOJ is up to once the current account
deteriorates further. We don't look at these trends as academic exercises,
but rather consider the risk of acting versus not acting. At this stage, we
assess the risk of not acting to be high and are putting our money where our
mouth is.

We have a Webinar coming up on Thursday, December 13, 2012. Please register to
learn more how we look at currencies to determine the strategic and tactical
outlook for currencies such as the yen and the dollar. Please also sign
up for our newsletter to be informed as we discuss global dynamics and
their impact on gold and currencies.

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard
money, macro trends and international investing. He is considered an authority
on currencies.

The Merk Absolute Return Currency Fund seeks to generate positive absolute
returns by investing in currencies. The Fund is a pure-play on currencies,
aiming to profit regardless of the direction of the U.S. dollar or traditional
asset classes.

The Merk Asian Currency Fund seeks to profit from a rise in Asian currencies
versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies
that may include, but are not limited to, the currencies of China, Hong Kong,
Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea,
Taiwan and Thailand.

The Funds may be appropriate for you if you are pursuing a long-term goal
with a currency component to your portfolio; are willing to tolerate the risks
associated with investments in foreign currencies; or are looking for a way
to potentially mitigate downside risk in or profit from a secular bear market.
For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges
and expenses of the Merk Funds carefully before investing. This and other
information is in the prospectus, a copy of which may be obtained by visiting
the Funds' website at www.merkfunds.com or calling 866-MERK FUND. Please
read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in
currency exchange rates will affect the value of what the Funds own and the
price of the Funds' shares. Investing in foreign instruments bears a greater
risk than investing in domestic instruments for reasons such as volatility
of currency exchange rates and, in some cases, limited geographic focus,
political and economic instability, and relatively illiquid markets. The
Funds are subject to interest rate risk which is the risk that debt securities
in the Funds' portfolio will decline in value because of increases in market
interest rates. The Funds may also invest in derivative securities which
can be volatile and involve various types and degrees of risk. As a non-diversified
fund, the Merk Hard Currency Fund will be subject to more investment risk
and potential for volatility than a diversified fund because its portfolio
may, at times, focus on a limited number of issuers. For a more complete
discussion of these and other Fund risks please refer to the Funds' prospectuses.

This report was prepared by Merk
Investments LLC, and reflects the current opinion of the authors. It
is based upon sources and data believed to be accurate and reliable. Merk
Investments LLC makes no representation regarding the advisability of investing
in the products herein. Opinions and forward-looking statements expressed
are subject to change without notice. This information does not constitute
investment advice and is not intended as an endorsement of any specific investment.
The information contained herein is general in nature and is provided solely
for educational and informational purposes. The information provided does
not constitute legal, financial or tax advice. You should obtain advice specific
to your circumstances from your own legal, financial and tax advisors. As
with any investment, past performance is no guarantee of future performance.